Roku Shares: A Bet on the Channel Guide to TV’s Future

The television set has been an obsession for information technology companies for decades, as one after another sought to dip a toe or more into TV’s enormous advertising pool, hoping to stir the waters.

The biggest disrupter, of course, is Netflix (ticker: NFLX). It launched “binge watching” in 2007, which began the steady erosion of “appointment” TV.

Walt Disney’s (DIS) most recent quarterly earnings report was the eighth straight in which the company’s network advertising revenue declined. Comcast (CMCSA) has been declining in video subscribers for nearly a decade.

TV’s been beat up, it needs help, and that’s a great opportunity for an “arms merchant” focused on the medium’s future. “People still watch TV,” Anthony Wood, chief executive of 16-year-old Roku (ROKU), told Barron’s last week. Wood, who speaks in calm, measured tones, enjoys pointing out the simple things people have misunderstood.

Wood himself seems obsessed with TV. Before founding Roku in 2002, he sold a prior company, ReplayTV, a competitor to TiVo (TiVo), which eventually ended up in the maw of DirecTV, a unit of AT&T (T). Wood, 52, was also briefly head of internet TV at Netflix. Roku started out making a little box to run Netflix on a TV. It then expanded to a line of player devices that can stream lots of different content.

But Roku now is mostly a software company, not a hardware maker. Increasingly it’s the graphical user interface for TV brands that don’t want to make their own software. It’s a home page for viewers, a portal into a constellation of 6,000 channels of video.

The company hit what might be a tipping point in the first quarter of this year. Its revenue from advertising and subscriptions, which it splits with partners, overtook hardware sales. Roku’s intent is to generate more of that “platform” revenue from users, who now total 20.8 million—a number that surged by almost 50% year-over-year in the most recent quarter.

Roku’s software runs one-quarter of so-called smart TVs, sold in the U.S., up from one-fifth a year earlier, on sets built by TV makers including China’s TCL (000100.China) and Japan’s Sharp (6753.Japan). That is second only to Samsung Electronics (005930.Korea), which had a third of the market, at last count, with its “Tizen” operating system (OS), according to research firm IHS Markit.

Wood argues Roku provides a better user interface than the homegrown software that Samsung and others have been using. Reviews seem to bear him out. “Our belief is that all TVs are becoming smart TVs, and that all smart TVs will run an OS,” says Wood. “Just like a phone company doesn’t build their own OS, unless they’re Apple, unless you’re Samsung, you’re not going to be building your own smart TV OS,” he says.

Roku’s deep-pocketed rivals such as Google, which sells its Android software on some Sony (SNE) models, have so far gotten only a minimal share of smart TVs. That’s because, he contends, they are simply porting smartphone software to the big screen, which doesn’t work.

“We have the best streaming engineering team in the world,” says Wood. Netflix might have a bigger team, he concedes, but not better. “It’s about having high standards,” he says. “We built a team that are experts in this.”

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Amazon.com (AMZN), which also has made little progress, is obviously keen to keep trying to make set-top boxes because it wants a part of the $70 billion TV ad market. It recently struck an exclusive deal with Best Buy (BBY) to market TVs by Toshiba (6502.Japan), with Amazon software. “I’m sure they’ll get some success,” says Wood of Amazon, “How much, I can’t predict. But I do think that we will remain the leader and that our share of smart TVs is going to continue to grow.” The deal with Best Buy, he observes, locks Amazon out of big TV retailers like Walmart (WMT) and Costco Wholesale (COST).

That’s important because working closely with a number of brands and retailers leads to success, he points out. In preparation for one Black Friday sale, Roku re-engineered the Wi-Fi chips in some TVs to lower the manufacturing cost by 50 cents per set just to please Walmart.

The reward for such dedicated engineering is a share of the market for traditional TV advertising and subscription revenue worth $1,000 annually per household. By contrast, Roku’s average revenue per user of $15 annually leaves plenty of upside.

Being the front page of TVs, “we can deliver [the audience] to TV advertisers that they can no longer reach in linear television,” says Scott Rosenberg, Roku’s vice president of advertising.

“For the adults [in the age] 18-to-34 segment, for example, 10% of that audience is only reachable on Roku,” says Rosenberg. “We go to an advertiser, and we say, you want to keep reaching those viewers in the living room, the only way to reach 10% of those viewers–going on to 15, 20, 30% over time–is to invest with Roku and reallocate your budget.”

In a world of tech giants keeping an eye on TV, Wood’s company could certainly be a takeout target. The shares are not expensive; in M&A terms, they’re actually dirt cheap, at just five times this year’s projected revenue of $695 million.

For a small investor, it will be important to watch the key metrics of number of users, and average revenue. Those items matter as much–if not more than–revenue growth and profitability. At a recent price of $35, Roku stock is up 50% since its public offering in September. The company is still losing money, but headed in the right direction: Roku this month raised its outlook for 2018, saying a small operating profit is possible.

TV is bruised but it’s not beaten. The little software company obsessed with TV’s future has relevance that’s worth taking note of.

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